Oil Stocks Deeply Oversold

Oil stocks have been
hammered especially hard in the recent stock-market correction. With
both the general stock markets and price of crude oil falling
sharply, the oil stocks didn't stand a chance. The result of all
this carnage is deeply-oversold oil stocks, a fantastic buying
opportunity for speculators and investors.

Oil stocks, of course,
are in the business of exploring for and producing crude oil. Thus
it is not surprising that the price of oil is one of their primary
drivers. Higher oil prices make oil more profitable to produce, and
the greater an oil company's profits the higher its stock price
will be bid. So oil-stock traders naturally watch the price of oil
closely. But provocatively oil shares its primary-driver role.

This sector's other
primary driver is the general stock markets. When the S&P 500
(SPX) is rallying, oil stocks climb in sympathy even if oil happens
to be flat. When the SPX falls sharply, oil stocks follow it lower
even if oil is rallying. So like most commodities-stock sectors, the
fate of the oil stocks is inexorably intertwined with the ongoing
fortunes of the general stock markets.

A couple years ago I
did a
study on the relative influence of oil and the SPX on
oil stocks. Both had nearly identical correlation r-squares
(nearly 90%) with the flagship XOI oil-stock index between 2003 and
early 2008. Sometimes oil was more important, and sometimes the SPX
was. But the oil stocks' performance was the best when both these
primary drivers were rising and the worst when both were falling.
And often oil prices moved with the SPX as stock-market fortunes
influenced commodities traders, something we've seen recently as
well.

Since April, both crude
oil and the general stock markets have suffered through the largest
corrections of their cyclical bulls. Seeing both of oil stocks'
primary drivers down hard simultaneously had a devastating impact on
oil stocks. Widespread fears, most of which were pretty irrational,
drove oil stocks down to unbelievable lows. If you want to buy low,
fear is your friend. This week it drove the best oil-stock
buying op that we've seen in at least a year.

To understand how
deeply oversold oil stocks became this week, you have to understand
the technical context. I've included cyclical-bull charts for oil
and the oil stocks, which are quite compelling. A third chart, the
SPX cyclical bull, is also very important for oil stocks. But I
discussed that last week in another essay on the general
commodities-stock
buying op, so here I'll just reference last week's
SPX chart.

We have to start with
oil, which has just weathered the biggest correction of its entire
cyclical bull. In addition to the usual oil technicals, this chart
also shows oil relative to its 200-day moving average in light
red. This important metric from my simple yet powerful Relativity
trading system helps traders identify and capitalize
on excessively overbought and oversold conditions in real-time.

Like everything else
during the infamous stock panic, oil was driven to irrational
deeply-oversold levels in late 2008 and early 2009. But since then,
it has skyrocketed 152% higher at best in a powerful cyclical bull.
This performance is stupendously good, reflecting how silly the low
oil prices were in early 2009. For reference, over a similar
timespan the flagship SPX stock index only rallied 80%. Oil has been
a rockstar!

Like all bull markets,
oil periodically experienced sharp corrections along the way. These
are healthy and normal events that rebalance sentiment, keeping greed
from getting too excessive before a bull climaxes. Prior to our
latest correction, the first 4 oil corrections averaged 15.4% over 24
trading days. And as you can see above, these corrections were all
very similar in magnitude with no major outliers.

Despite these sharp
corrections from time to time, oil continued to power higher on
balance in a strong uptrend. By early April 2010, it was approaching
$87. This was a far cry from the ridiculous $34 levels it had
briefly languished at just 14 months earlier. After topping, oil
consolidated high in mid-April averaging $85 on close over the
subsequent 3 weeks until the SPX topped on April 23rd.

At that point, the US
stock markets started pulling back. And as is usually the case,
retreating stock markets spawn endless worries about the economy.
When oil-futures traders see weak stock markets, they assume the
global economy must be weakening too and therefore near-future oil
demand won't be as strong. So oil tends to get sold in sympathy
with major SPX retreats.

If you compare the oil
chart above to last
week's SPX chart, the temporal correlation between
oil corrections and SPX pullbacks and corrections is dead on. Since
last summer, the big oil corrections noted above have usually
coincided with major SPX retreats. In addition, weak stock markets
drive flight capital into
the US dollar and Treasuries. Since oil is
denominated in US dollars, dollar rallies drive global oil prices
lower. Thus SPX retreats hit oil on two fronts, the
economic-sentiment one and also the stronger-dollar one.

The net result of the
biggest SPX correction of its cyclical bull and the strong dollar
rally since late April was the sharply-lower oil prices we've just
seen in oil's 5th major correction. This all-important flagship
commodity plunged 20.0% lower over 36 trading days ending in late
May! In addition to being about a third bigger and half-again longer
than the average of the previous 4 corrections, this latest one drove
oil below its uptrend's support and 200dma to deeply-oversold
levels.

Oversoldness is
measured from a gradually-changing baseline, and the 200dma is the
perfect one. Relative to its 200dma, oil fell to its lowest levels
in 12 months. Between 2005 and 2008 prior to the stock panic,
we used a relative trading range for oil of 0.98x to 1.25x. Under
0.98x was very oversold, the time to go long. And when oil surged
over 1.25x its 200dma it was very overbought, the time to close longs
and add shorts. By late May in this latest correction, oil plunged
under 0.91x its 200dma! With the exception of the wild stock-panic
span, oil hadn't been this oversold since early 2007 when it traded
in the $50s.

While oil's
correction matches the SPX's own perfectly, another important
psychological event happened right before it began in earnest. On
April 20th, Transocean's Deepwater Horizon drilling rig exploded in
the Gulf of Mexico. A couple days later, it sank in 5000 feet of
water. Of course the tragic wellhead blowout that doomed this rig
also led to the catastrophic oil spill in the Gulf that is saddening
the world today. Much of oil's correction coincides with this
growing oil spill, so some analysts claim the two are related.

Fundamentally though,
this doesn't make any sense. The horrible economic impact of this
massive oil spill has understandably fanned anti-drilling sentiment
to previously-unimaginable heights. This oil spill will make
drilling much harder and more expensive in the future as oil
companies are forced to jump through endless new hoops. Any event
that reduces future supply is fundamentally bullish, not
bearish.

Even if this tragic oil
spill had never happened, oil still would have experienced its
largest correction of this bull because the SPX was weathering the
largest correction of its own bull and the US dollar was soaring. If
anything, the Gulf oil spill's psychological impact on future
drilling probably retarded oil's latest correction a bit.

With both oil and the
SPX down sharply in their biggest corrections of their bulls, the oil
stocks were doomed to spiral lower. And they certainly did! This
next chart looks at the XOI oil-stock index, which has just fallen
off a cliff. While very painful for existing oil-stock investors,
this massive decline has driven the best buying opportunities we've
seen in oil stocks since at least last summer. They are deeply
oversold.

As oil stocks didn't
fall as low as oil during the stock panic, they didn't rebound as
far as oil after it passed. The XOI is only up 48% at best in its
cyclical bull to date, well underperforming oil's 152% and the
SPX's 80%. This is certainly disappointing, but it is largely
explained by the gigantic oil stocks that dominate the XOI. Not only
do they typically trade at lower valuations than the broader markets,
but their market capitalizations are so enormous that their stocks
are slow to move. Kind of like oil supertankers.

The XOI's major
retreats prior to this latest correction mirror oil's exactly, and
of course most of oil's mirror the SPX's. But the XOI has been
more volatile than either of its primary drivers. Running between 7%
to 16%, the standard deviation of the XOI's pullbacks and
corrections was much wider. The first 4 prior to today's averaged
11.1% over 26 trading days. This helps show how crazy the XOI's
latest correction has been.

Between April 23rd, the
very day the SPX topped but 3 weeks after oil did, and this
Wednesday the XOI plunged 22.0%! As you can see in the chart, this
correction was gigantic. It doubled the preceding
bull-to-date average over a period of time about a quarter longer!
The result was a shattering of the XOI's consolidation support line
and deeply-oversold levels approaching a 14-month relative low. Oil
stocks were just taken out behind the barn and shot, practically
abandoned.

The elite oil companies
are so enormous that the impact of a 22% loss in the XOI is
staggering. At the end of April, the 13 XOI component companies had
a collective market capitalization of $1232b. Meanwhile the
entire Dow 30 sported a market cap of $3638b, or $3154b if you
remove its two giant oil-stock components (XOM and CVX) that are also
in the XOI. So the XOI oil companies alone were almost 40% of the
size of all 28 non-oil Dow 30 components!

This implies a total
loss of elite-oil-stock market capitalization in this correction
approaching $267b! A 22% correction in the major oil stocks is a
huge deal! Of course the catastrophic plunge in the former British
Petroleum exacerbated the overall XOI decline. In late April, BP
alone represented around 13% of the entire market cap of the XOI
oil-stock index. Peak to trough since the Deepwater Horizon
explosion, BP's stock has lost a staggering 52% of its value. This
translates into around $90b in market-cap terms.

So without BP stock's
death spiral, the XOI's recent correction would have been milder.
But not dramatically so. As BP's stock was gradually cut in half
as the toxic crude continued deluging forth from its deep gusher, its
influence in the XOI waned. At worst, with a 1/8th weighting and 50%
plunge, it accounted for about 6% of the XOI's 22% correction. But
the reality is probably more along the lines of 3% to 4% thanks to
its declining weighting. So even ex-BP, the XOI's recent
correction was very large.

The oil-spill
psychology certainly had a major impact on this steep oil-stock
decline. The endless oil-spill images and coverage is making
everyone feel sad and helpless. Though this was the first disaster
after over 600 deepwater wells (a water depth beyond 500 feet)
drilled in the Gulf of Mexico, it has vilified the entire oil-stock
sector in the minds of pandering politicians and dimwitted Americans.
One blowout at one well owned by one company has tarred this
entire sector with a brush of loathing.

But while this spill is
terrible and catastrophic and tragic, the world economy marches on.
The world is still consuming crude oil at far-faster rates than new
reserves are being discovered and brought online. With this kind of
supply-demand imbalance coupled with half the world's population in
Asia rapidly ramping up its per-capita energy consumption, higher oil
prices for years or even decades to come are inevitable. The only
source for this oil is the oil companies, all of which except BP had
nothing to do with this spill.

The Marxists running
Washington are making this situation even worse for American
consumers and more bullish for oil prices. Now they consider a
1-in-600 catastrophic failure a high-probability event and have
banned deepwater drilling. This kneejerk reaction is driving
drilling rigs to other countries. Oil companies need to make
reservations to lease these rigs years in advance. So
American oil production in the Gulf is going to be lower for years
to come thanks to the Obama Administration's irresponsible
grandstanding. This virtually guarantees higher gasoline prices for
American voters for years to come.

Higher oil prices,
whether driven by Chinese and Indian consumers or knucklehead
American politicians, are great for oil stocks. So this
deeply-oversold buying opportunity created by the combination of a
large oil correction, a large SPX correction, and oil-spill
psychology should be seized by prudent speculators and investors.
Many smaller oil producers actually fell much farther than the giant
majors of the XOI. The small oil-stock bargains are the best we've
seen since the stock panic in many cases!

At Zeal we've been
aggressively buying oil stocks in recent weeks as the XOI plunged.
Most of these purchases were made in our popular weekly Zeal
Speculator newsletter. We're sifting through the
carnage to find smaller high-potential oil producers drilling and
pumping in promising oilfields here in the States and abroad. These
small oil stocks should easily double over the next year as oil and
the SPX recover, and it wouldn't surprise me to see them triple or
quadruple. Today's opportunities are amazing.

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The bottom line is oil
stocks are deeply oversold today. A sharp general-stock-market
correction spawned the pessimistic economic psychology that led to a
concurrent sharp oil correction. As always when both of their
primary drivers are falling fast, oil stocks got hammered. But this
time was even worse due to the flood of negative emotions the
terrible oil spill has understandably unleashed. Oil stocks were
sold with reckless abandon, leading to some of the best bargains
since the stock panic in some cases.

But while the
irrational oil-stock fear we've seen in recent weeks will soon
pass, the global need for crude oil will not. As always after
oil-stock corrections, this sector will be bid back up almost as fast
as it fell. Contrarian speculators and investors willing to fight
the crowd and buy today's bargains before mainstreamers catch on
will be richly rewarded. Oil stocks are deeply oversold, and such
emotionally-driven conditions never last.

Adam Hamilton, CPA

June 11th, 2010

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